Equities rallied last week and continued to do so on Monday. High-yield and investment-grade bonds did so as well, points out Russ Koesterich, BlackRock’s chief investment strategist.
But it isn’t time to pull out the party hats, says Koesterich in a note to investors on Monday. “Unfortunately, investors still face a bevy of challenges,” he explained.
While the risks of a recession seem to have moderated, weakness in corporate earnings has not, the head of model portfolios for BlackRock points out.
Yet another challenge is what the Federal Reserve does next.
“The Fed is likely to be true to its word and proceed cautiously, but inflation has strengthened, suggesting that the central bank may not be quite as dovish as the market expects,” he added.
No Change Ahead?
While there’s an upbeat shift to the markets, the fundamentals governing them “have not changed much,” according to Koesterich.
Oil rallied recently as producers said they are considering a plan to stick to January production levels. However, this depends on their reaching the right agreement — namely one that “can correct the excess supply problem that has led to the plunge in prices,” he explains.
Furthermore, it isn’t clear that such a deal will hold, since Iran hasn’t committed to capping production; plus, Iraq and Saudi Arabia boosted production last month, while Russia is close to its maximum, the BlackRock strategist points out.
As many energy market analysts continue to argue, at existing levels, there remains too much supply. “U.S. oil inventories recently reached their highest level in 86 years,” Koesterich said.
Overall, the global economy is “in the midst of a deepening profits recession,” he adds.
Earnings per share estimates for the S&P 500 are dismal, predicting a drop of nearly 4% in 2016 and close to 5% this quarter, Koesterich explains. In Europe, the forecasts are even more negative.
“In a world in which central bank policy is both less available and less potent, volatility is more likely to remain above its historical average,” the BlackRock strategist cautioned.
With soft growth, tightening financial conditions and falling inflation expectations, central banks in Europe, Japan and even China should continue to ease monetary policy, he notes, but the Fed “is in a bit of a bind.”
While economic data, in particular manufacturing figures, are weak, U.S. core inflation has ticked up to 2.2%, which is “the fastest pace since the fall of 2008,” he says. “Prices on imported goods, both oil and non-energy-related products, continue to fall, but housing and medical inflation are accelerating.”
As many portfolio managers believe, the chances that the Fed will raise interest rates four times in 2016 (as it suggested it would do so in December) are slim. The futures market, though, is suggesting that central bankers won’t sit out the full year. “As such, any hikes would represent a more hawkish stance than the market is currently discounting. If this occurs in the context of a stronger dollar, it will represent a further tightening of already challenging financial market conditions,” Koesterich said.
This means several things for investors.
First, the Fed probably won’t provide the same support of asset prices as it has done in recent years, he explains.
Second, given that central bank policy is both less available and less potent today, volatility should stay above its historical average, according to the strategist.
Finally, inflation expectations are likely “too low,” according to Koesterick.
“Even in a world of slow growth, weak productivity and diminishing labor market slack, inflation may be higher than today’s diminished expectations suggest. Under this scenario, Treasury Inflation Protected Securities (TIPS) may represent a good long-term opportunity,” he explained.
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